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Proper planning is essential to the success of any business. While most owners have well-written plans for operating their businesses, very few have effective plans to deal with issues that may arise between shareholders.

If you have clients who run businesses with multiple shareholders, ensure they have properly structured shareholders’ agreements to protect everyone’s interests. The best time to implement an agreement is when business is good, shareholders are happy and everyone is talking. Waiting until one of the “D” life events (death, disability, divorce) will be too late. There is no substitute for good corporate governance.

In its simplest form, a shareholders’ agreement is a contract that governs the relationship between the shareholders. If structured properly it can help regulate a company’s operations should this relationship fail or should one party need to leave the company.

Failure to plan properly could impact the company and impact the shareholders’ abilities to realize value on their shares. A well-drafted agreement can also be used as an efficient and effective mechanism for business succession, either to the next generation or to a third party.

No two businesses are alike. While there are a number of issues such as shareholder compensation (e.g., dividend policies), maintaining adequate insurance (on key employees and shareholders) and operating guidelines, this article will deal primarily with those shareholder agreement provisions dealing with a shareholder departure.

If dealt with properly, the company can continue to run smoothly when faced with circumstances such as death, disability or a shareholder’s retirement.

The objectives of a properly structured shareholders’ agreement generally include:

  • Determining current and future share ownership
  • Ensuring an orderly transition for a shareholder departure
  • Restricting the ownership and transfer of shares
  • Providing a market (or value) for share transfers
  • Protecting the interests of minority shareholders
  • Dispute resolution

With these overall objectives in mind, a well-thought-out agreement should be implemented to address shareholder- and business-specific issues. Before drafting an agreement you should address the following questions:

  • What will happen when a shareholder leaves the company?
  • Will the departing shareholder be subject to a non-competition clause?
  • How will a passive shareholder be compensated compared to an active shareholder?
  • Can a deceased’s family member become a shareholder of the company?
  • Who can purchase the shares and at what price?
  • How will the shares be valued?
  • How should the buyout be structured to minimize tax and cash flow?
  • How will the remaining shareholders fund the buyout?

Once you’ve addressed the above questions, consider the solutions. Some typical strategies are provided below, but each shareholder should obtain his own independent professional tax, legal and accounting advice.

Pre-emptive rights to share offerings

Current shareholders are offered the right to maintain their percentages of ownership by acquiring a proportional number of any new shares issued.

Right of first refusal

Shareholders selling shares must offer them to existing shareholders first. Providing a right of first refusal is an effective method for maintaining a market for the shares as well as controlling who will become a shareholder of the company.

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